Commentary on Economics, Information and Human Action

Economic experimentation, economic growth, and regulation

For much of the past year I’ve been thinking about experimentation and the role that experimentation plays in economic activity and value creation; my post on Jim Manzi’s book earlier this week is in keeping with my interest in this topic. When I reflect on the processes of value creation and economic change that we observe in the real world, I see experimentation everywhere — firms experiment with new business models, new products and services, new modes of organization; consumers experiment by exploring, trying out new products and services, to learn whether or not things they haven’t tried before would give them more enjoyment, better enable them to thrive, or not be worth purchasing or consuming again. In this way, both producers and consumers are entrepreneurs, and when firms profit from having created new combinations that consumers try and like and purchase and recommend to their friends, that’s an example of the role that experimentation plays in value creation. And particularly in the forms of technological change and ensuing commercial innovation (and subsequent technological change, lather-rinse-repeat) that we’ve experienced over the past two decades, the role of experimentation in value creation is even more obvious.

There’s actually an academic literature on this topic in management and organizational theory, including contributions from my colleague Shane Greenstein, who is the world’s foremost expert on the economic history of the Internet and its development and organizational structure. Shane also writes at a wonderful blog, Virulent Word of Mouse. Shane’s work draws largely on Nate Rosenberg’s important work on the economic history of technological change. Rosenberg’s article Economic Experiments, in the inaugural volume of Industrial and Corporate Change, defines economic experiments as encompassing market experiments leading to new products and new technologies as well as “experimentation with new forms of economic organization”. Rosenberg then goes on to argue that the freedom to engage in economic experiments is one of the causal factors in the unprecedented economic growth and industrialization in countries like Britain and the United States.

One of the insights from Shane’s analyses of the market for Internet access (and, in an as-yet unpublished paper, wireless Internet access) is that economic experiments enable firms to benefit from experiential learning — economic experimentation enables them to learn things that they cannot learn in any other way, because they put products and services out for consumers to experiment with and choose, or not. Absent this process of market experimentation, firms have limited access to the private, subjective knowledge of individual consumers because otherwise they only have indications about consumer preferences and perceptions from focus groups or controlled laboratory experiments. Why is the knowledge created and captured in this market experimentation so valuable? For one thing, it communicates that subjective, diffuse private knowledge of consumers to firms, signals that they see in data on adoption rates, revenues, and profits/losses. For another, market experimentation is a process through which consumers themselves create knowledge as they learn their preferences, tradeoffs, willingness to pay for some features of products and services. Those consumers do not, and cannot, know those preferences before they actually confront those options in a real situation in which they can make a choice among the various alternatives presented to them. Only by market experimentation with the actual technologies, products, and services as they are available in the market can both firms and consumers learn what value consumers attach to them and what ways they will create and what applications they will find of them that the producers did not envision at the outset.

You probably recognize the argument I just made as an Austrian knowledge-based argument for market experimentation. In an article in Organization Science (2000), Scott Shane draws on Austrian economics to make a related point, that when technological change occurs, market experimentation allows entrepreneurs to discover how best to exploit the new technology. He grounds his argument in Hayekian diffuse private knowledge that is only accessible to others via market signals such and prices and profits/losses. The profits earned or losses incurred indicate the value consumers can generate with the technology, product, or service, as well as whether the firm has an organizational structure enabling it to control the costs of bringing this new value proposition to market.

In all industries and markets, regulatory policy affects the extent to which such economic experimentation can occur. Some regulations restrict the nature of new technologies, products, or services that can be offered to consumers (think, for example, of all of the debate over the past three years about retail financial services and the new CFPB). Some regulations either directly or indirectly affect the scale and scope of the organizational structure that firms can have. Some regulations restrict entry into the provision of specific technologies, products, or services (one example here is occupational licensing, which erects entry barriers). And some regulations do all three of these things, stifling economic experimentation in multiple dimensions.

Traditional electricity regulation restricts product and service characteristics and restricts entry, thereby reinforcing the old vertically-integrated monopoly utility organizational structure (three for three in my above taxonomy). Not surprisingly, then, this is an industry in which exogenous technological change and pervasive economic dynamism in the rest of the economy has been so slow to penetrate, because traditional cost-based regulation of vertically-integrated monopolists presents sizable barriers to economic experimentation. If Rosenberg and Greenstein and Shane and others are correct that the freedom to engage in economic experiments is one of the most significant causal factors in economic growth, the limit on economic experimentation in an industry that is so intimately connected to innovation and well-being and thriving in so many dimensions of our lives is an exceedingly costly limit that electricity regulation imposes on all of us.

In another post I’ll say more about what costs might arise from economic experimentation in the electric industry.

It’s not only cost-of-service regulated areas that sees this problem. Areas with centralized forward capacity mechanisms (PJM, ISO-NE) also greatly restrict innovation, because the parameters of centralized procurement are constantly being determined by a stakeholder process rather than a decentralized market. Price signals that would encourage innovation and efficiency are stifled as well.

The industry took a few wrong turns in the past decade in many places in the US.